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A Bottom, but Maybe Not
by David Coffin and Eric Coffin

The spring in the financial sector’s step last week has some wondering if bottoms are finally forming in for the equities market. This is based on an assumption that weak banks couldn’t get much cheaper and that, to Wall St’s way of thinking, a “real” bull rally has to be led by financials. Certainly its true there is much less $ (or £, or €) value that can be chopped off them than has already been. Early year profits indicated by some the larger and weaker US banks, and comment by US Fed Chairman Bernanke that the recession could be over by year’s end if the banking sector stabilizes, also helped the cause.

Of course this enthusiasm does ignore that the going from anywhere to 0 is a 100% loss so financials are not exactly risk free. Concern about whether some banks need to be nationalized in order to induce some true stability is not yet off the table. The detail of the early year profitability is yet to be laid out, and it came with cautions that Q1 still has a month to go. Banks’ operating profits can build through a quarter only to be lost on booking off capital requirements and write downs. Wall St views too much that looks bad as a one time event that shouldn’t be included in “real” earnings. Losses are losses where we come from.

The big news of last week was Bernanke finally pulling the trigger and starting a program of quantitative easing, or money printing as they call it in the old country. Things have gotten to the point that Helicopter Ben will be second guessed on every move he makes. We think that you have to start with the assumption that the Fed has some data in hand that we mere peons are not privy to. Given that he made the decision after equity markets had already put in a substantial rally this was not the Fed coming to Wall St’s rescue. It was the Fed coming to the bond market’s rescue.

Yields on the 10 year Treasuries had been creeping inexorably upwards for over a month. As we have noted several times in the past few months, the Fed has to find ways to allow the Treasury to sell a mountain of paper without driving up interest rates at the worst possible time. Buying Treasuries will serve the dual purpose of pulling down rates and pumping money into the US economy. The announcement helped create the biggest one week loss for the US$ ever. As we note below, traders fear this makes an inflationary endgame all but assured when the economy really starts to recover.

After a 15% move, the major markets look ready to take a breather. We’d like to think we have seen the bottom in the markets but there is still a lot of bad news to get through. Earnings season starts in two weeks. No one expects good numbers. The real question is how much of the bad stuff is priced in. No one will know the answer to that question until we see how traders react but we are still holding to the belief that a bottom is likely to come during the summer doldrums. It may not be much lower than this month’s but another revisit of the lows seems the most likely course of events. We also can’t help but wonder if the Fed’s move means there is another shoe left to drop that the rest of us don’t know about yet. It’s hard to imagine there are any new sources of bad news left, but it hasn’t paid to make that assumption for two years.

Despite the improved credit markets we are still in a cash-driven market. China and other creditor economies are right to insist on seeing the rot dug out of the system before doing any more to help fix it. China already has a large cash infusion moving into its economy, and indicates it expects a loss on its plans to buy more US treasury paper. It has also made it clear it sees no reason to expand its spending plans, at this point. It, and others with functioning banking sectors, will increasingly refocus on workarounds to avoid western banking.

The issue that would be of most concern to us seems, right now, to be the least contentious. There appears to be agreement to avoid hampering global trade, at least overtly. Protectionist measures were one of the worst problems of the dirty 30s, and so far governments are shying away from them. Hopefully that continues. Markets will react badly if it doesn’t.

China’s government has been replenishing its stockpile of copper, which has helped reduce warehoused copper available through the LME by 10% in two weeks. The warehouse offerings have been reduced in part because copper users themselves are more willing to hold inventory. China’s buying helps, but so does an easing of credit conditions that makes cash generation less urgent. Since we are cautious about unfinished debt-crisis business in the financials sector, we also have to remain cautious about the strengthening copper price. Current LME copper warehouse stock levels are is still 45% above the start of this year, and 300% of last year’s lows after all.

With a shift away from the greenback, we could well see more copper price gains regardless of changes to warehouse stocks. These would be real in so far as copper should reflect the inflationary pressures in the US that is inherent to a $ weakening. However, we would still like to see continued reductions to commercial stocking levels support any price gain for the red metal, rather than simply its return to the currency system. It’s worth noting that if China adds the amounts rumoured (700,000-1,000,000 tonnes) to its government stocks and leaves it there, this year’s expected copper surplus will disappear. The Chinese buyers are not fools. They were the ones selling $4.00 copper to hedge funds, after all. We think their statement of intent is real but that doesn’t mean they will either chase or drive the price higher.

Announcement of a move by the US Fed to buy the long end of its bond market also had the expected impact on the gold price. Having consolidated to the US$900 per ounce level, we think it likely it will now be a “currency of choice” in a move away from the US. Gold (and most other commodities) have gone back to their anti-dollar status. After moving with the Dollar since the start of the year correlations have again reversed. There are many who place undue faith in the ability of the Fed to reverse the sort of trades it is about to start. It’s common for the Fed to undertake small scale refi activity and reverse it later. The difference this time is the operations will be several orders of magnitude larger. Even assuming the Fed wanted to reverse them (a big if at this point), it can’t do it in the midst of the Treasury’s funding campaign without blowing up interest rates.

A more important question is how other central banks will react to these moves. More of them may feel compelled to follow the US lead if only to help maintain competitiveness of local products. To the extent that commodities continue to be viewed as currency proxies that cannot be created out of thin air this should help metals and energy prices. It will however make price changes more unpredictable. While the situation is clearly bullish don’t think that these latest Fed moves have made gold or anything else a straight one way trade. There is no reason to expect volatility to fade away any time soon.

Below is a one year gold lease rate chart from Kitco http://www.kitco.com/. Even when debt conditions are normal gold leasing typically runs at sub 0.5% rates. These rates surged last October in a way not seen since 9/11 2001, though it should be noted this recent spike was only to half the level during the 2001 terrorist fears.

Short term leases rates have settled back to near nothing, which is in keeping with weak manufacturing demand. Though 6 and 12 month rates are lower they have settled near the 1% mark. This is unusually high and especially given very low central bank rates. A 1% premium is however a low priced insurance policy against the possibility of a currency crashing. That is still gold’s major function, and we expect it to grow as US$ easing continues.


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